With market activity on the rise, we are regularly faced with entrepreneurs that do not understand the concept of Enterprise Value.
Just as the term implies, Enterprise Value is the sum of both the debt and equity capital in a business. This is a similar concept to the value of your home. For example, if you own a home worth $500,000 and have a mortgage for $200,000, then your equity value in the home is $300,000. Similarly, if a purchaser was prepared to pay you five times last year’s EBITDA (assume for this example $1.0 million), this would equate to a $5 million Enterprise Value. If you owe the bank $2 million in debt, then the value the shareholders would receive (prior to the tax implications) would be $3 million.
The problem is that many entrepreneurs believe they will receive the $5 million themselves, and in addition, the buyer will assume the $2 million of debt which is not the case in business acquisitions. If this were the case, then the Enterprise Value of such a transaction would actually be $7 million ($5 million of equity + $2 million of debt), which in our example would equate to seven times EBITDA, rather than the five times EBITDA the acquirer offered.
Enterprise Value usually entails one further pricing consideration, and that is the amount of working capital included in the purchase price. There is no set rule for determining the level of working capital however, this is normally determined through negotiation. In simple terms, buyers would expect to receive enough working capital to operate the business in a similar manner as the existing owner.
So remember, if you receive an offer for a company that is referred to as Enterprise Value, or the purchase price is referenced to a multiple of EBIT/EBITDA, this purchase price is the debt-free value, with a possible adjustment for excess/insufficient working capital in the company.
This article was written by Ron Dersch and was published in the March, 2006 issue of M&A Today.